What the IMF Chief's Arrest Means for the European Debt Crisis

The big news over the weekend was the arrest of Dominique Strauss-Kahn who is the managing director of the IMF and had his sights on the French Presidency. Strauss-Kahn was arrested while sitting on a plane bound for a meeting with German Chancellor Angela Merkel to discuss the European sovereign debt crisis. His arrest will undoubtedly complicate the negotiations underway today in Europe.

While Strauss-Kahn awaits his first court appearance on attempted rape charges, Greece will be pleading their case for a restructuring of the 110 billion euro bailout they received from European governments and the IMF. Germany in particular is demanding Greece make deeper budget cuts in exchange for extending the maturities or increasing the amount of aid.

German Chancellor Angela Merkel has been taking a tough line with Greece, and has also been wanting the owners of Greek debt to share in the costs of any restructured bailout. This is making many of the largest European banks a bit nervous, as they hold a large amount of the Greek debt. But over the weekend the parliamentary leader of Merkel’s Christian Democratic bloc seemed to leave an opening for Greece to squeeze into. Volker Kauder suggested that there could be a ‘soft restructuring’ of the Greek debt which would involve the extending of the maturities.

If you ask investors, Greece is all but guaranteed to default on their debt no matter how long the maturities are extended. 85% of international investors surveyed this week by Bloomberg said Greece would default, and a majority also believe Portugal and Ireland will be unable to pay back their debts. The outlook in Europe has certainly taken a darker path since the beginning of the year when it looked like the worst of the European sovereign debt crisis had passed.

But the economies of Portugal, Greece, and Ireland are still struggling to recover. Portugal’s economy slipped back into recession during the first quarter of the year. GDP in Portugal was announced this morning and showed it had dropped 0.7% from the previous quarter when it was down 0.6%. Economists had predicted the drop, and it confirms that additional aid may be needed as the PIIGS economies struggle to recover.

Even with all of the sovereign debt worries, some are still predicting the euro (EUR) will rise. Société Générale SA raised its year-end forecast for the euro against the dollar on last week’s higher German and French growth numbers. Société Générale, the second-largest French bank forecasts the euro will reach $1.52 by year-end and $1.55 in 12 months. The head of foreign exchange strategy at the bank cited the higher growth figures, and expectations of higher rates compared to the US dollar as reasons for the increase in their call for the euro. Growth in Europe is twice that of the US, and the ECB will be raising rates sooner than the Fed. Interest rate differentials are important in currency valuations, and especially when a central bank is seen as being ‘in front’ of the inflation curve. While the US could be caught leaving rates too low for too long, the ECB looks to start tightening in an attempt to head off inflation.

To no one’s surprise, consumer prices in the US rose in April led by increases in food and fuel. The CPI increased 0.4%, which was expected, but the FOMC pays more attention to the ‘core’ measure ex food & energy which increased just 0.2% on the month. The YOY figures were a bit more disturbing, with the overall number rising 3.2% and the core number showing a 1.3% increase. To see the ‘real’ inflation numbers, readers should go to John Williams’ website, where the inflation rate is reported using the traditional calculation methods and is shown to be in double digits (10.7% YOY in April). Here is the website for those readers who aren’t familiar with it.

Business economists aren’t falling for the ‘official’ CPI numbers, and are beginning to get worried by the higher prices. A survey conducted by the National Association of Business Economics showed that economists’ growth expectations have been lowered. Consumer and business spending will probably increase less than projected three months ago, while employment forecasts were revised up.

Climbing prices in the US along with the sovereign debt crisis in Europe have again combined to put fear back into the minds of investors Friday and over the weekend. Risk was taken off the table, and the US dollar and Japanese yen (JPY) were the big winners. Equity markets and commodities all traded lower Friday, and continued to drop in early European trading.

Lower commodity prices pushed the value of the ‘commodity currencies’ down again on Friday. The New Zealand dollar (NZD) and South African rand (ZAR) were the most dramatic victims, falling nearly 2% versus the US dollar in the past two days. The Brazilian real (BRL) and Australian dollar (AUD) also got sold as the commodities, which are so important to both economies, decreased in price. The Australian dollar was also pushed lower by a report that showed Australian home loan approvals fell to the lowest in more than 10 years in March. Many investors now feel the Reserve Bank will delay future interest rate increases as another report released last week showed that employers unexpectedly cut jobs in April.

The Canadian dollar (CAD) fell to a six-week low as commodities and equities losses sapped demand for the loonie. The general ‘risk off’ sentiment that swept through the trading desks on Friday caused investors to sell everything except the US dollar and Japanese yen, and the Canadian dollar got sold. It seemed like a knee-jerk reaction, as I typically don’t consider the Canadian dollar a ‘high yielding’ currency. If the Canadian dollar continues to fall, it could present an excellent opportunity for those who felt like they had ‘missed the boat’ on getting into the Canadian dollar over the past few years.

The Indian rupee (INR) is getting sold in the currency markets in spite of a report that showed India’s inflation was faster than estimated in April. Higher prices will add to growing pressure for another interest rate increase following the 50 basis point increase on May 3rd. India’s economy is expected to grow at an 8% pace in 2011 after growing 8.6% last year. The government raised fuel prices by 5 rupees a liter last week, the biggest increase since June of 2008. I would expect to see the Reserve Bank of India continue to move rates even higher as they try to combat inflation, which should give good support to the Indian currency.

And finally, the US is set to hit its $14.3 trillion debt limit later today. Over the weekend Republicans spelled out their demands for spending cuts, which will need to accompany their votes for an increase in the debt ceiling. Everyone realizes the ceiling will be raised, but Republican congressmen are taking advantage of the timing to push major spending reforms as part of the deal. Senate Republican leader Mitch McConnell is calling for a two-year spending cap, as well as cuts to both discretionary and mandatory spending in the near and long term. Democrats agree that spending needs to be slowed, but also want to raise taxes. President Obama and Treasury Secretary Geithner have struck a dire tone, warning the Republicans about the ‘irrevocable damage’ to the nation’s economy, which would result from even a short-term default. I certainly wish they would look at the ‘irrevocable damage’ they are doing to the long-term prospects of the economy by continuing to print money!

To recap: The IMF chief was pulled off the plane as he headed to a meeting on the Greek situation; the euro sold off as the Greek crisis continues. US CPI numbers showed inflation is moderate, but still picking up. A commodity selloff has pushed all of the ‘commodity currencies’ down. The Indian rupee sold off in spite of a report that will likely force further rate increases by the Indian reserve bank. And the US debt ceiling will be hit today, but there isn’t really any doubt that it will be raised.